Business Valuation: Everything You Need to Know

Business valuations are the process of figuring out the value of a company or business.9 min read

What Is a Business Valuation?

Business valuations are the process of figuring out the value of a company or business. Small business valuations are often about finding the lowest prices that someone would pay—known as the floor—and then figuring out the highest price that someone would pay—known as the ceiling.

Why Get a Business Valuation?

There are many reasons you might want to get a valuation on your business.

You are going to sell your business or acquire a new business. You might need to sell the business you are retiring, have poor health, are getting a divorce and you and your spouse own the company, or due to other family reasons.

You are developing an exit strategy and need to know what the business is worth.

You are planning to buy out one of the owners or take on a new owner and need to know what the value of their piece of the business is.

You want to get financing from banks or private investors. Potential financiers or investors will want to know that the business has worth.

You are transferring shares that will have a gift or estate tax impact.

You are trying to get life insurance.

You are dealing with legal issues like contractual disputes, commercial litigation, personal injury claims, or wrongful death claims. In order to assess the amount of money owed to you, the court will need to know the value of your business.

The Process of a Business Valuation

If you are planning on using an attorney to help you with your business valuation, the process will include a few steps:

First, you will have a meeting with a few business lawyers that you have selected through careful research or recommendations from trusted businesses in your field. During the meeting, you should discuss the reason you need the valuation, talk about the business that you want valuing, the nature of the company, and the date you need it valued for.

Once you choose a lawyer that best fits your needs, you will sign an engagement letter that will outline the terms of the work that your attorney will carry out. You will send some information for consideration. Keep in mind that every valuation is different, but generally, the requested information consists of historical financial statements and tax returns, governing documents, information about the management team, forecasts, budgets, accounts receivable aging reports, accounts payable information, and a detailed management questionnaire that you will have to fill out.

Then the attorney will ask for a management interview to better understand the business. If a site visit is an important part of the valuation, the meeting will often take place at the company site.

The attorney will then check all the information you have given them as well as the information they received during your meeting. They will look at the assets, income, and market valuation approaches and applicable valuation methods. They will then come to a conclusion and draw up an analysis document. If you have any questions about the valuation, you'll need to set up a follow-up meeting with the attorney to discuss them.

What Does a Business Valuation Tell Me?

A well-prepared valuation will not only give you the value of your business but also a lot of other information that you may find valuable:

A summary of facts about the company's products, services, customers, employees, suppliers, and facilities.

The rights and obligations associated with owning securities in your business.

A comparison of your business' historical financial performance to other similar firms.

Present and future expected economic conditions and industry trends.

The expected income and cash flow that the business will create in the future.

Any risks associated with your business, such as working issues and market volatility.

The risks that come along with selling your interest in the company to a competitive and unrestricted market.

The current market value of some of the assets owned by the business and the liabilities owed to creditors.

A quick comparison of your business next to those that are publicly traded and similar firms that have recently sold in mergers and acquisition transactions.

Asset Based Valuations

Asset-based valuations take all of your business' assets and liabilities into consideration when valuing the company. If your company has a lot of goodwill or other intangibles that you feel are an important part of the value of your business, something other than an asset-based valuation may be the best method for your company.

There are two common ways to value businesses under the asset-based method:

Book value. Book value is the "owner's equity" number on your balance sheet. You will have to adjust the book value in the valuation process to recast your financials. The current adjusted book value will be the "bare minimum" value of your business.

Liquidation value. Liquidation value is the amount that left over if you had to sell your business quickly, without taking the time to get the full market value, and then used the proceeds to pay off all debts. This value isn't a true value but would be used in times of desperation.

Historical Earnings Valuations

The historical earnings method allows the business to place a value on the goodwill over and above the market value of the assets. The assumption made with this type of valuation is that your history gives an idea of the amount, predictability, and growth potential of your future earnings.

There are several options to consider if you are going to value your business using the historical earnings method:

Debt-paying ability. This factor ensures that your business can generate enough cash to pay off loans within a short time, usually four to five years. To figure out a company's debt-paying ability, you need to look at the historical free cash flow. Free cash flow is the company's net after-tax earnings, minus capital improvements and working capital increases. Then you need to add the depreciation back in and multiply the annual free cash flow by the number of years the acquisition loan will run. Then subtract the down payment from that amount. The number you are left with is the amount available to make interest and principal payments on the loan.

Capitalization of earnings or cash flow. Using this method, you will find out the figure that represents the historical annual earnings of your company. Usually, this is your earnings before interest and taxes (EBIT), but sometimes you use earnings before interest, taxes, and depreciation, instead. Once you have selected one of those two, divide it by a "capitalization rate" that represents the return the buyer requires on the investment.

Gross income multipliers and capitalization of gross income. If the expenses in the industry you are in are highly predictable or the buyer wants to severely cut expenses after buying, then you might want to value your business using a multiple of gross revenues. This means you divide the gross income figure by a capitalization rate.

Dividend-paying ability. This is a method that the IRS states as a good valuation method for small businesses. That being said, this method is rarely used by small businesses. Whether a small business can pay dividends or not is directly related to their earnings, so it makes more sense to simply look at the earnings themselves. Small businesses usually try to lower the amount of dividends they pay because of tax purposes, so looking at their past dividend payments would not be a good sign of the value of the business.

Market-Based Valuation Methods

The market-based valuation methods look at the market price for similar businesses at a specific time. Business brokers and mergers and acquisition specialists usually favor these methods, because are able to look at the data of recent sales and mergers.

Market-based methods should really be used along with an examination of earnings—historical or projected—so that you have a real check of the market against the success of the business:

Comparable sales method. The comparable sales method locates businesses that are similar in size and industry that have recently been sold in your area. It then uses those figures, making adjustments based on differences, to set a price for your business. This is a difficult method to use when valuing businesses because it's difficult to gather information about small businesses.

Rules of thumb/industry averages. This method is usually used by business brokers. They base the value of the business on their experience and on published standards for the industry. The rule of thumb method doesn't account for the fact that your business is unique. It can often result in a price that is either far too high or far too low. Small businesses valuations are usually done using the rule of thumb because it is fast and cheap.

Profit and earnings ratios. This method uses the profit and earnings of publicly held companies in the same industry to set prices for liquidating stock in large businesses. If you are a small company, it's best not to compare your profit and earnings to those of large publicly shared companies.

Times Revenue Valuations

The times revenue method gives a range of values for a business, based on revenues over a certain period. You then need a multiplier, which might be closer to one if the business is slow-growing, and it might be higher than one if the company shows proof of growth and expansion.

Earning-Based Valuations

This business valuation method considers the idea that a business' true value is in its ability to make money in the future:

Capitalizing past earnings. This is the most-used approach to earning-based valuations. Using this approach, you will find an expected future cash flow for the company. You'll do this using the company's past earnings. First, you have to normalize them for any unusual revenue or expenses. Then multiply the expected cash flows by a capitalization factor. A capitalization factor is the rate of return the purchaser would expect to receive on the investment.

Discounted Future Earnings. Instead of taking a look at the average of the past earnings, you take an average of the predicted future earnings and divide it by the capitalization factor.

Valuing Partial Interests in Business

Sometimes, you don't need to value the entire company. Instead, you want the value of only a small part of it. If you are selling off a part of the business or want to know the value of your share of the business, then you'll use one of the following methods:

Minority interest discounts. It is common to have one person in the company, usually the founder, hold over 50 percent of the company with smaller blocks of stock held by key employees or investors. If you're selling the entire company, there are laws that protect the minority interest holders and typically require that they will receive their pro rata share of the sales price.

If you're only selling or giving away part of the company, then you only need to value minority interests at a discount of their pro rata rate. A minority owner does not have much influence over the way the company runs.

There are exceptions to this rule. If no one has a majority interest in the company or if the company has specific bylaws that govern what will happen in this situation, then those take precedence.

Majority interest premiums. When you sell or give away a company, the value of the majority interests is more than their pro rata share of the company's value.

How to Improve Business Value

If you are not happy with your business' estimated value, there are several things you can do to increase it before a sale. You will need to start planning months or even years in advance in order to implement the changes that will substantially improve the value of your company.

Proven profitability and the potential for future earnings are the most attractive qualities to potential buyers. You should begin documenting a multi-year record of profits and positive cash flow. This can drive up the value of your company, especially if you use the earnings multiplier valuation method.

It is also important to position your business for future earnings. You should identify all of the advantages your business currently has or will have in the future in the market. For example, future prospects can be a factor in driving up the value of your business.

Basic organization can improve your business's value. If you can demonstrate carefully maintained financial records, documented employee policies, a neat and clean facility, you are improving the value of your business. The easier it is for buyers to understand your business and see themselves at the helm, the more likely you are to get a higher price for your business.

Seller financing can improve the value of your business. While financing part of the sale is not an option for every seller, buyers will pay more for businesses that include some level of seller financing. This is especially true in tight credit markets.

Sellers should also realize that they may need to get the help of a qualified business appraiser or broker in order to truly and accurately value their company. A good appraiser or broker, with experience in your industry, can shorten the sale process and ensure that your business is priced to sell in the current market.

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